The coronavirus, or Covid-19 pandemic, has thrust the world onto a path leading to an economic collapse of epic proportions. In this constantly-updated blog we follow the progress of the crisis.
The Stage of the Crisis: The beginning of the Flood
Updated 15/07/2020 (previous update 13/07). All updates are presented in bold.
In the December 2018 issue of our Q-Review, we outlined the likely scenarios of an approaching global economic collapse. But, like most things in life, such a dramatic event is unlikely to proceed in a purely linear fashion. There will be different stages within it.
In December 2019 we outlined these stages, which are likely five: the onset, counter-attack, flood, calamity and recovery. Here, we briefly define the characteristics of each, updating them with recent information.
The Onset of the crisis
In the Q-Review 4/2019, we specified that at the onset, stresses that had been building in the credit markets since the summer of 2019 would explode, shrinking if not eliminating entirely the exits from many parts of that market.
Downgrades of corporate debt in the U.S. and peripheral sovereign debt in the Eurozone would push large fixed-income investors, including pension funds, into higher-rated bonds, which would in turn lead to large-scale selling of lower-rated bonds, forcing wider spreads and even more selling.’
This moment came in late February 2020, when a sudden panic gripped investors in both credit and equity markets after a surge in reported Covid-19 cases and deaths in Italy coincided with the collapse of OPEC talks. Stock markets crashed and spreads in the credit markets exploded. A frantic retreat to ‘safe-haven’ assets, including U.S. Treasuries, German Bunds and U.K. Gilts as well as cash and precious metals commenced.
For a brief period of time in mid-March, we were on the brink of a complete financial market meltdown. Then, as we also had envisaged in December, there was a frantic rush on a never-seen-before scale by global and local authorities to rescue the situation.
We envisaged that the second phase of the collapse would be the desperate efforts of authorities to stop the crisis by a counterattack.
We said these were likely to include the restarting and acceleration of QE programs and other market support initiatives, gigantic fiscal stimulus, increasing trade protectionism and possibly even calls for direct debt monetization (see Q-Review 3/2019 for an explanation).
These tactics are now in effect in full force. The U.S. government has applied an absurdly enormous stimulus program of $2 trillion with the near-certainty of more to come. Governments all over the world have pushed vast amounts of debt-financed stimulus into their respective economies. This seriously undermines their ability to respond to future shocks, while simultaneously creating a massive number of “zombie” corporations.
The Fed has now become the financial market as it backstops U.S. Treasury markets, intervenes in corporate commercial-paper and municipal bond markets and short-term money-markets. Massive support by the FED and the “free money”-schemes of the government have levitated U.S. stock market valuations to levels not seen since, at least, the height of the “Tech Boom” in 1999.
Recently the Fed has shifted its focus from supporting the financial markets to lending to states and corporations. It remains to be seen how well the “hyper-inflated” asset markets are able to absorb such a massive change, considering the seriously damaged economic landscape, with over 18 million insured unemployed (some 30% of American households missed their housing payments in June).
The potential roadblock to the “counterattack strategy” of the ECB set by Germany’s Constitutional Court (CC) was dismantled in early July, when Germany’s Bundestag (parliament) backed the Public Sector Purchase Program (PSPP). However, new lawsuits against the ECB, more precisely, against the Pandemic Emergency Purchase Program (PEPP), are being planned. Pressure against the ECB will thus keep on building.
These are strong forces pushing against the Counterattack.
If the desperate efforts of global authorities to uphold the credit and stock markets succeed, as it now seems they may, we will still be faced with a flood of corporate bankruptcies.
In December 2019, we asserted that the so-called “zombie” corporations, faced with collapsing global economic demand will start to fail on a scale unseen in decades. Unemployment will skyrocket and tax revenues will collapse. And, at some points, credit markets will crash despite of the massive efforts of central banks. We also envisaged that:
If one or more European banks weakens or fails, it will be likely to send the capital markets into a similar downward spiral.
Next, we detail the Flood phase in three crucial countries/areas: the U.S., the Eurozone and China.
The United States
Soon, the zombie corporations may represent 20% of US firms.
The first signs of the “Flood” in the U.S. are now clearly visible. The bankruptcies of J.Crew Group and J.C. Penney, among other large American retailers, and the collapse of Hertz, an American-based global auto rental company giant, are only the beginning.
Statistics by the American Bankruptcy Institute show that corporate bankruptcies have soared. Nationwide Chapter 11 filings nearly doubled Y-o-Y in May. Many states saw filings grow in excess of 40% since May of 2019. Moreover, analysis by Goldman Sachs found that the number of bankruptcy filings is now the highest since the GFC. Moreover, in mid-June, the weekly US bankruptcy filings accelerated to their highest level since May 2009.
These, most likely, indicate the we are at the beginning of the Flood.
It’s estimated that over 10 percent of companies in Europe are ‘zombies’. Their existence is also tightly connected to the existence of weak (or zombified) banks.
The profitability of European banks after the GFC has also been dismal, and as we explained in Q-Review 3/2019, these banks have been hamstrung both by OMT and QE programs and the negative rate policy imposed by the ECB.
However, the biggest risks to European banks lie in the hidden corners of their balance sheets. The finances of several major European banks are burdened by worthless assets which the banks, with the blessing of the European Banking Authority and national authorities, are permitted to pretend to have some actual value.
The presence of such assets slowly decaying on a bank’s balance sheet serves to drains its income as well as its ability to take risks in its lending activities. Applied across the banking sector, such regulatory malfeasance “zombifies” the banks, and presents a substantial burden for bank management.
The ECB’s stress test, published in October, showed that half of the biggest banks in the Eurozone would not survive if financial counterparties and some commercial clients pulled their money from the banks. This is exactly what happens in a recession, which has now definitely arrived.
China’s GDP shrank by -6.8% (Y-o-Y) in Q1, which is the largest decline since at least 1992. The situation becomes even more worrying when one considers that Chinese economy has become mostly consumer-driven, like the US, and that the coronavirus hit the micro, small- and medium-sized companies the hardest, which provide 90% of all employment.
The Chinese banking sector is also teetering on the edge of collapse. The China Banking and Insurance Regulatory Commission has warned that lenders are facing a surge in bad debt as the economy sputters. The banking sector has grown to an unimaginable size, and the risk of catastrophic bank runs is growing rapidly.
China is desperately trying push more fiscal and monetary stimulus into the economy, but due to the collapse of global economic demand such attempts will be wholly inadequate.
Skyrocketing unemployment is very likely to collapse highly-inflated real estate and financial bubbles. These, combined with the crash in global demand, will result in a Chinese economic ‘hard landing’.
When corporate failures, or the Flood, truly begin, this will be visible both in the financial markets and in the public sector. Several sectors of the financial markets are likely to witness massive turbulence, collapsing prices and even complete implosion, similar to the recent cataclysm in the oil markets.
For example, Collateralized Loan Obligations, or CLOs, when faced by a deluge of corporate failures, and a resulting downgrade to “junk” status, can leave lenders unpaid due to weakly-written covenants. A few prominent defaults could eliminate market liquidity leading to the collapse of the entire $1.4 trillion CLO market.
The value of the holdings of public and private pension funds, charitable endowments, bank trust funds, insurance company general and variable accounts, and stock and bond mutual funds will crash in short order in the Flood. Even lowly money-market funds may be at risk, just as they were in the 2008 financial crisis.
An utter economic collapse, Calamity, will follow.
Massive global deflation will appear, led by an ugly chain of bank and corporate failures. Global liquidity will collapse and stock markets will crash in a spectacular fashion.
Due to both crashing capital markets and banking sector bankruptcies, joblessness and poverty are likely to explode. Simultaneously, government tax revenues will collapse as incomes retreat and capital gains evaporate.
As governments spending skyrockets in an orgy of Keynesian counter-cyclicality, national deficits will hit all-time highs on both an absolute and relative basis. Those central banks that have initiated debt monetization will have no alternative but to accelerate their programs. In their desperation, many other central banks are likely to follow.
Governments will try to save critically-important banks, which will require large-scale funding many countries—such as those in the Eurozone—cannot afford and will not be able to finance in paralyzed capital markets. This economic reality makes depositor bail-ins the only, if politically-unpalatable, option.
Confronted by new and harsh fiscal realities, pensions and other social security programs are likely to face serious cutbacks, by desperate governments. An economic calamity sets in.
However, even grimmer scenario exists. If the virus mutates and start to spread rapidly around the world during the fall of 2020 and continuing into the winter, we could be facing an utter economic annihilation. Unfortunately, accelerating growth rates of Covid-19 cases in the US and in Latin America demonstrate that the likelihood of a second wave is growing fast.
Countries across the world would be forced to reinstate broad and draconian lockdowns leading to complete breakdown of supply-chains. Global logistics routes would be disrupted by huge numbers of sick (or frightened) employees and the strict closures of both factories and national borders.
These ghastly factors, combined with soaring unemployment, business failures and market turmoil would topple the global banking sector. Bank losses would be likely be so great that though depositor bail-ins would be enacted, they would be insufficient to keep banks from failing.
The European banking sector would be likely to collapse completely, followed by an implosion of the global financial order. Global commerce would evaporate. The world would succumb into utter economic annihilation.
This would be a scenario of an “economic apocalypse“. We could witness never-before-seen unemployment, wide-spread poverty and riots with some weaker countries succumbing into state of anarchy.
Unfortunately, things could get even worse, if the central bankers would enact the final step in their monetary destruction -scheme: the helicopter drops. They would bring an end to the monetary system as we currently know it.
If the full socialization of our economies and financial markets does not occur, we expect the global depression to last 3-5 years. The initial collapse is likely to be over within three years (2020-2022).
Thus, the path to recovery will depend crucially on how far the ‘cleansing’ of the economy, markets and financial sector is allowed to go. If the banking sector implodes completely, the economic deficit will naturally be made much deeper leading to a systemic crisis.
However, if the essential functions of the banking sector are sustained, especially in Europe, we could avoid the deepest malaise. Moreover, if unsound banks and “zombie” corporations are allowed to go under or are wound-down methodically, it will clear much of the malinvestment from the economy, creating the foundation for a strong and sustained recovery.
So, if we manage to return to the principles of the market economy including, most crucially, a return to undistorted price discovery in the capital markets, we are likely to see one of the most powerful recoveries in global economic history. It would be led by robotization and general technological innovation, which hard economic times tend to foster.
However, debt monetization, Modern Monetary Theory (“MMT”), helicopter drops and other money-conjuring schemes would corrupt the economy further making a sustained recovery impossible (see more from Q-Review 4/2019). This, unfortunately, is the path we currently are on.
Moreover, with the governments and the central banks assuming a much bigger role in the economy and society in this darker scenario, some form of fascism (which is, by definition, the merger of state and corporate power) would be the likely end-result of these developments.
We can do nothing more than hope that wise, courageous and far-sighted political leadership will spare us from that horrible fate.
Following the coronavirus outbreak, junk bond yield-spreads shot-up. They were first tamed by massive support operations launched by major central banks, but have refused to “normalize” (see Figure 1).
It’s clear that the ‘zombified’ junk-rated companies cannot endure elevated yields and collapsing demand for very long before they start to fail. The massive unemployment already visible in many countries, is likely to be the main driver of corporate bankruptcies worldwide.
Moreover, the Nikkei Asian Review has calculated that quarter of world’s largest companies are in risk of running out of cash, if there’s a 30% drop in sales lasting for a period of six months. That would result to defaults of large companies but also to a swathe of bankruptcies of smaller companies, sub-contractors, etc., which depend on the income streams from large, multinational companies.
We are, most likely, in the beginning of the Flood. How fast the Flood stage fully engages depends on the effectiveness of the desperate actions of governments and central bankers across the globe. But there are strong forces ‘countering’ the Counterattack, including the very high unemployment rate in the US and risks in the financial system.
Currently, the main risks lie in the US stock markets and in the European banking sector.
We expect the European banking crisis to start in Italy. Its banks have the worst capital ratios, the performance of its banks in general has been dismal, and Italy’s government debt-to-GDP ratio is already very high at 135% at the end of 2019 (see Q-Review 6/2020 for a detailed explanation). The coronavirus and lockdowns have also dealt a crushing blow to tourism, one of the main sectors of the Italian economy. It is almost certain that its banks will not be able to stand the strain.
The European banking crisis is likely to commence in the fall, when the full economic hit of the pandemic will become visible, with or without the possible second wave of Covid-19.
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